Understanding the MACD indicator...

What is the MACD indicator and how can it be applied to stocks?

MACD or Moving Average Convergence Divergence is a trend following indicator that measures the relationship between two moving averages. The indicator is plotted as an oscillator that shows overbought and oversold readings along with signals of the change in direction of the trend. The indicator can also be plotted as a histogram, and when it extends above the zero line, it depicts overbought and when it runs below the zero line depicts oversold.

Although personally I tend to ignore the histogram and focus on the MACD & Signal lines only.

Here is the Tesla chart with the MACD indicator plotted at the bottom.

Construction of MACD

As can be seen in the picture above, the MACD indicator is made of two lines, which cross themselves often and then go up and down together for extended periods.

One of these lines is called the MACD line (blue line) that is plotted using values derived by subtracting two exponential moving averages. Generally, these moving averages are 13-period and 26-period EMAs. These parameters can be changed based on the trader’s preference.

MACD = short-period EMA - long-period EMA

Another line, called the signal line (red in the above chart), is plotted along with the MACD line. The signal line is the exponential moving average of the MACD.

The histogram in the MACD indicator is computed as the distance between the MACD line and the signal line.

In a 12-26-9 MACD, The 26-period EMA is subtracted from the 13-period EMA to arrive at the MACD value, which is then plotted on the chart as the MACD line. A 9-period moving average of the MACD is plotted as the signal line.

You can customize the parameters of the MACD based on your trading style and the timeframe. There can be multiple variations of the MACD and many of those variations work quite well for traders.

Again, personally I use the weekly time frame for my MACD analysis and it forms the foundation of my strategy - My Strategy - Click Here

Reading the MACD

A buy signal or start of an uptrend is when the “MACD line” crosses above the “signal line” and vice versa for the sell signal or the start of a downtrend. Similarly, a histogram reading above zero signals a buy and start of an uptrend, and a sub-zero reading signals a sell and start of a downtrend.

The further the lines get from each other, the more extended the price move. Likewise, the bigger the histogram bars get on either side, the more extended is the price move.

As the MACD is the difference between a short-term EMA and a relatively long-term EMA, a steeply increasing or decreasing MACD denotes that the recent price move has been sharp on the upside or downside, respectively.

Applying MACD to stocks

Many stock traders use MACD to trade trends and it works quite well in trending markets. The indicator can be applied to any time frame, from intraday to positional.

If you are an intraday trader, you can use the MACD on shorter timeframes like minutes or hours to get trading signals and ride the trend. A daily or weekly timeframe will suit you if you are a swing trader, while you can choose between daily, weekly, and monthly or a mix of the three if you are a positional trader.

Here is a 30-minute chart showing a number of decent intraday trading opportunities.

While trading using the MACD, you must first take a look at the long-term trend of the stock. If the stock is in a strong trend, you would do well if you trade in the direction of the trend.

*I use the 20 week moving average as the longer term trend indicator*

For example, in the above chart of Apple Inc., the stock has been trending strongly on longer-term charts (daily and weekly), which is why the up moves were quite healthy, while the down moves were modest consolidations. This would always happen in strongly trending stocks.

Therefore, the best way to trade such stocks is to do nothing in consolidations and wait for the MACD signal to trade in the direction of the long-term trend.

A long-term rangebound stock will give you both, long and short opportunities, which will be equally good.

The same rule can be applied while swing trading stocks using the MACD.

Shortcomings of MACD

As mentioned in the previous section, MACD works best in strongly trending markets. The other times it might not be as useful, unless the markets are truly in a range, gyrating from one point to the other in a consistent fashion.

In non-conducive, erratic markets, MACD can give many false signals, leading to a number of bad trades and a streak of losses.

Conclusion

MACD serves as an oscillator and also as a crossover indicator. Though the indicator might look quite straightforward and rewarding at the first look, it’s not the holy grail. It works wonders in some markets, while, in other markets, it gives numerous false signals.

Relying solely on MACD can be troublesome if you have not thoroughly tested the indicator in your trading style.

It works well if used with other indicators and technical tools.

It’s always better to have a birds eye view in trading and trade when multiple indicators are pointing in the same direction.

The key is to know when will the indicator works and when it will not. Once you find a market trend that’s perfect to trade using MACD, seize the moment and trade optimum position size and gun for big moves. The other times, tighten your stop losses, trade light, trade another suitable strategy, or simply do nothing and save your capital.

My Strategy - Click Here